Description

Summary

Align Technologies, Inc. (NASDAQ: ALGN), “Align,” is a $15 billion market-cap medical device company that designs, manufactures, and markets Invisalign clear aligners and iTero intraoral scanners and services for orthodontists and general practitioner dentists, and restorative and aesthetic dentistry. The company effectively invented, and won, the clear aligner category and continues to dominate it today with over 75% market share of all clear aligners. We’d like to be clear that we think the franchise is a strong one - Align is a great success story, having grown sales and EBITDA at a ~20% CAGR over the past 15 years. There have also been previous write ups on this website and elsewhere about competition, but in the past few years Align has crushed its competition and that is not the short thesis here.

The short thesis is that numbers are much too high for Align. We think there’s some major anchoring bias coming into play, and the street does not appreciate how much one-time revenue the company got during COVID. As we go forward to a normalized environment, and perhaps one where the macro is shaky, we think there’s considerable downside in Align estimates, and therefore its share price. This is despite the fact that shares are already down 70% YTD. We believe this thesis is unique as short interest is only ~4% of float and 2 days to cover.

Investment Thesis

After growing revenue and case volume at 20-25% annually from 2010-2019, Align’s growth exploded to 50-60% in 2021 due to an aggregation of unique factors. 

One behavioral factor was the zoom effect, named after the ubiquitous video calling app, which was caused by people spending hours staring at themselves on video screens everyday while working from home. As a result of this mandatory “self-reflection,” masses of people decided their teeth needed adjusting while they were locked down at home (and also since they could mask while in public). The major financial factors driving their purchase decision were wealth effects from rising asset prices and higher disposable incomes from fiscal stimulus checks.

We believe COVID-fueled growth was one time in nature, and included substantial pull forward of future revenue. Those that were going to fix their teeth over the next few years took the opportunity to do so during COVID times. Given that treatment times are 6-18 months in length, those that started teeth alignment in late 2020 and 2021 are finishing up their treatments this year. Going forward, we don’t believe the company has enough revenue to replace revenue that is rolling off now. In addition to the pull forward, we believe demand is also impacted by the fact that there’s a well-documented, nervous and/or weakening consumer. Invisalign is a discretionary and substantial purchase at a cost of $3000-6000 for a treatment, and often not covered by insurance. 

We believe this slowdown has already arrived, and our conviction in this thesis comes directly from a significant number of diligence calls with competitors, industry groups, dental organizations and most importantly, doctors both in the US and internationally.  We spoke with multiple “diamond level” Invisalign doctors who are in the 1% of all prescribers of Invisalign by case volume. All doctors indicated a slowdown in their business, with one very high volume doctor indicating that their 2022 year would end down 10%+ vs. 2019 levels. 

We also point to a few other things supporting our thesis about top line slowing substantially more than the street expects:

• Social media trends have been weakening across the board including Instagram hashtag usage decelerating, Tiktok mentions decelerating, Reddit posts decelerating, Facebook group new member adds slowing, Linkedin hiring slowing, app downloads slowing on multiple major app trackers including Appannie and Sensortower, etc. 
  
  

• Inventories at Align are at starting to pile up, up to 32 days of sales - the highest on record outside of June 2020 due to COVID.
  
  The company has indicated it ordered extra inventory due to supply chain constraints, and the bulk of the increase has been in work in progress and raw materials. However we still believe that indicates a slowdown of end demand as they are not processing aligners at the same rate they were just 3-6+ months ago. And finished goods in particular - something the company should not have very much of - has been climbing significantly compared to sales.
  
  
  

• Deferred revenue growth has decelerated considerably from pandemic highs so the company is not collecting payments from new customers as fast as it is burning through deferred revenue:
  
  
  

• Days Sales Outstanding, a metric that has been incredibly steady for a long period of time, jumped up to an elevated level in March and has remained that way.
  
  And going along with this, for the first time that we can find in the company’s public history, Align factored $23mm receivables - so the actual Q3 2022 A/R is slightly worse than what is shown above. It is a small overall number ($23mm vs. $860mm of receivables), but we’re scratching our heads as to why the company would need to do this
  
  

• We found this language inserted into the most recent 10Q’s MD&A section. We’re not fully sure what it means, but it seems like hedging language admitting to uncertain demand going forward.
  

Estimates and Downside

Prior to COVID, revenue was running at $2.5-3bn per year. 2021 and 2022 revenue came in between $3.5-4bn per year. And estimates going forward call for flattish revenue. We believe the answer is somewhere between pre-covid and post-covid revenue which means there’s still up to 25% downside to revenue estimates. Perhaps even more downside if the experience of our diamond level doctor is more widespread. For example, utilization on a per-doctor basis in North America is 27% higher than 2019 levels. We see LOTS of room for normalization here no matter how you cut it. 

Meanwhile, growth estimates for 2023E call for 0% growth, and for 2024E 13% growth off the 2023E elevated base. Estimates also show a jump in gross margins. We think those numbers are significantly at risk.

In Q1 of this year, Align stopped giving guidance. We think this is indicative of the clear uncertainty Align is facing in their business. However, street estimates therefore exhibit an anchoring bias each quarter. Every quarter, the company misses estimates and models are adjusted down for that quarter and then estimates grow quarter-over-quarter off the new base. This remains the case now where consensus models have taken a reported quarter and grown it sequentially from here: 

What we’re looking for is a reset of expectations down to a lower base. It’s possible the company does this when it announces Q4 earnings, and potentially reinstates giving guidance for 2023E. And while we’re not focusing on it, ASP compression and continued gross margin headwinds are a clear possibility here as well.

Valuation and Price Target

Align has always traded richly - at 30-40x P/E over the past 10 years. We think much of that multiple has been warranted in the past, but while estimates/numbers are coming down we think the current 20-25x multiple is more appropriate.

We think 2023E earnings per share are likely to decline from ~$8/share today to closer to $6. Applying a 20-25x trough P/E multiple to our estimate of earnings suggests a $120-150 stock price, or a decline of 20-40% from current levels. 

A final note: we’ll reiterate again that if the stock price drops to $120-150, we’d look to go long. Align is a dominant franchise with limited genuine competition and opportunities in continued penetration (including new markets in Teen aligners and international geographies). We believe off a lower base, the stock is likely to compound capital for many years to come.

Catalyst

2023E Guidance if reinstated

Quarterly results